The short butterfly is very similar to the long butterfly but bullish on volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread. A short butterfly can be constructed using calls or puts. Using calls, the short butterfly can be constructed by writing one lower striking in-the-money call, buying two at-the-money calls and writing another higher striking out-of-the-money call, giving the trader a net credit to enter the position.
Limited Profit
Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.
If the stock ends up at the lower striking price, all the options expire worthless and the short butterfly trader keeps the initial credit taken when entering the position.
However, if the stock price at expiry is equal to the higher strike price, the higher striking call expires worthless while the “profits” of the two long calls owned is canceled out by the “loss” incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial credit taken.
The formula for calculating maximum profit is given below:
- Max Profit = Net Premium Received – Commissions Paid
- Max Profit Achieved When Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call
Limited Risk
Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchange at expiration. At this price, only the lower striking call which was shorted expires in-the-money. The trader will have to buy back the call at its intrinsic value.
The formula for calculating maximum loss is given below:
- Max Loss = Strike Price of Long Call – Strike Price of Lower Strike Short Call – Net Premium Received + Commissions Paid
- Max Loss Occurs When Price of Underlying = Strike Price of Long Calls
